Stripped mortgage-backed securities , Financial Management

Assignment Help:

These securities aid in unpacking the cash flows from a pass-through. The most uncomplicated stripped mortgage-backed securities are the PO-IO-security. Unlike a pass-through security which distributes the entire cash flows in equal proportion to all investors, the (principal only) PO-IO (interest only) creates two securities. The PO-IO aid in hedging, interest rate and prepayment risks. 

The POs get all the principal flows from each mortgage payment. They are sold at a significant discount to par. The cash flows typically are low in the beginning which increase with time as the principal component of the mortgage payment grows. The PO investor receives the entire par value of the PO .

The IOs get all the interest flows from each payment. The cash flows are very huge in the beginning and get smaller with passage of time. Therefore, they have a shorter life. The IO strips have the risk of receiving cash flows with low value than expected because the interest produced depends on the beginning-of-month balance of the pool. The IO investors may end up with cash flows in falling interest rate scenario as the mortgage rate will be paid off sooner than estimated.

Investment Characteristics of POs and IOs:

  • The investment performance of POs is highly sensitive to the prepayment rates. As prepayment rates rise with a decline in mortgage rates, prices of POs increase as interest rates fall.

  • The price of an IO security is positively related to the mortgage rates at low existing levels. A decline in market rates below that of the mortgage rates results in an increase in the prepayment rates and a fall in principal amounts. Interest payments to the IO fall as they are based on the principal outstanding on the underlying pool. The cash flows to the IOs improve when the interest rates increase above the contract rate.

  • Unlike pass-through securities, POs and IOs demonstrate higher price volatility, since the returns on these stripped securities are negatively correlated, that is, their prices move in a direction opposite to that of the interest rates. However, their combined volatility is equal to the price volatility of the pass-through security.


Related Discussions:- Stripped mortgage-backed securities

Price volatility characteristics of option-free bonds, As we know tha...

As we know that price of option-free bond changes in the opposite direction from a change in bond's required yield, Table 1 and figure 1 explains this feature of

Capital structure decisions: the basics, i want some presentation slides of...

i want some presentation slides of this chapter from page 570 to 580

Accounting, Accounting : Many people believe financial management only r...

Accounting : Many people believe financial management only relates to bookkeeping and the establishment of accounting reports which reflect those transactions in the books.  Whi

305, I have an assignment due today and needs some help

I have an assignment due today and needs some help

Estimate working capital requirements, Q. Describes Working Capital. Briefl...

Q. Describes Working Capital. Briefly describe the techniques utilized in making working capital forecast or Estimating Working Capital Requirements? Ans:- Meaning of Wo

Expected monthly return, In this exercise you will construct efficient port...

In this exercise you will construct efficient portfolios with 5 risky assets using Excel's non-linear optimization routing "Solver". The questions are designed to be sequential and

ABF, HOW TO CALCULATE ASSESSED BANK FINANCE

HOW TO CALCULATE ASSESSED BANK FINANCE

Pay back period (pbp) , Pay Back Period (PBP) : This is the most popula...

Pay Back Period (PBP) : This is the most popular method employed by industrial practitioners for ranking investment projects. This is described as the "period required for a pr

Forms of liquidity, Forms of Liquidity: Definition: Liquidity defines ...

Forms of Liquidity: Definition: Liquidity defines to how quickly and cheaply an asset will be converted into cash. Money (in the form of cash) is the most liquid asset. Assets

Aims of financial services authority, Aims of FSA The aim of FSA is to ...

Aims of FSA The aim of FSA is to promote efficient, orderly and fair markets, and to help retail consumers to get a fair deal. In fact, FSA has set out its aims under three bro

Write Your Message!

Captcha
Free Assignment Quote

Assured A++ Grade

Get guaranteed satisfaction & time on delivery in every assignment order you paid with us! We ensure premium quality solution document along with free turntin report!

All rights reserved! Copyrights ©2019-2020 ExpertsMind IT Educational Pvt Ltd